Paul Hale and Martin Shah of Simmons & Simmons outline the implications of the Inland Revenue's discussion paper on the regulated funds regime.

Change is one thing, progress another. A recently published Inland Revenue discussion paper is intended to address industry concerns that the UK's tax system for regulated funds is outdated.

One view is that the current system limits the range of activities that may be carried out onshore in a manner that cuts across the FSA's deregulatory approach set out in the new collective investment scheme sourcebook (COLL).

However, whilst the snappily titled "The Tax Implications for Authorised Investment Funds following the new FSA Regulations (COLL)" highlights some of the issues, the potential options for change identified do not give much comfort that the desired innovation in the regulated universe will arise. It is hoped that from the debate which will no doubt follow publication of this paper, a sensible and competitive regime for fund taxation in the UK will be developed to cement the UK's position in the European fund management sector.

Authorised investment funds

The current regime for authorised investment funds [UK authorised unit trusts (AUTs) and UK open ended investment companies (OEICs)] can be summarised as follows. An authorised investment fund is treated as a company for tax purposes, but with a full exemption in respect of chargeable gains and a lower rate of tax (20%) on trading and other income profits.

The fund may pay distributions to investors either in non-deductible dividend or in deductible interest form, in the latter case only where the "qualifying investments" test is met throughout the relevant period.

Where a fund accumulates rather than distributes, it will still be treated for tax purposes as having distributed the whole of the amount available for distribution in the relevant period and its investors will be taxed on that basis.

This regime has proved satisfactory for existing authorised investment funds, but is not adequate for the wider range of investment techniques and asset classes permitted under COLL.

Particular problems arise with "trading" and real property.

The Inland Revenue approach

The Revenue in Tax Bulletin 60 suggested helpfully that there should be a "general and prevailing" assumption that an authorised investment fund is investing rather than trading. This may be difficult in practice to reconcile with the use of borrowing, complex derivatives and a high level of portfolio turnover. In the absence of more detailed guidance, one is left in the grey area of the "badges of trade" in identifying whether a fund risks being treated as trading for tax purposes.

This involves the consideration of a number of often conflicting factors, such as the motive for the transaction, the subject matter of the transaction (in particular, whether it relates to an income producing asset) and the period for which the relevant asset is held before disposal. Dealings in futures, options and other derivatives are generally trading transactions unless the purpose of the transaction is to hedge an identified capital asset or liability. Short transactions in securities would be likely to be considered to be trading but may, in the context of a fund's overall activities, not be sufficient by themselves to render the fund as trading.

COLL and qualified investor schemes

In traditional retail funds the distinction between (taxable) trading activities and (exempt) investment activities was generally easy to identify, but the changes introduced by the FSA through COLL have blurred the boundary. In particular, the ability of retail schemes and QIS (qualified investor scheme) funds now to utilise derivatives for investment rather than hedging purposes (provided they are globally covered), and for QIS funds to use leverage and short sell, may lead one to consider that they are trading, at least for tax purposes.

The discussion paper

The Revenue paper identifies six key areas where change may be required to address the new COLL funds. Taking these in turn:

Property funds

There is an acknowledgement that the current system discourages non-taxpayers from investing in property-holding funds, due to the 20% tax charge on rental income at the fund level and the inability to pay deductible interest distributions out of that income. One possibility identified would be to extend the streaming rules to permit rental income to be streamed in any distribution.

The paper also identifies a number of disparities between AUTs and OEICs in relation to stamp duty reserve tax and stamp duty land tax and queries whether any change to put these vehicles on an equal footing would be appropriate. The proposals to make authorised property funds more attractive to exempt investors are to be broadly welcomed, although any progress in this area must be considered in the light of the parallel consultation on the new property investment fund (PIF) vehicle.

Distribution rules

The paper considers a number of current issues with the distribution rules. The principal problem identified is with the somewhat inflexible qualifying investments test, which must be met throughout the whole of a distribution period in order for the fund to be able to pay a deductible interest distribution.

Given the wider range of assets in which a fund may invest, placing a restriction on a fund that it must hold 60% of its assets by market value in cash, debt securities or equivalents does not sit easily with the desire to allow a fund to diversify risk. One possibility identified is to extend the corporate streaming rules for dividend distributions to non-corporate tax exempt institutions, such as pension funds and charities. This would enable those investors to reclaim their portion of any residual corporation tax suffered at the fund level. The proposals to update the rules regarding when a fund can pay interest distributions and to extend the streaming rules to exempt investors are again a helpful update to an area where problems are increasingly common, given the growth in mixed funds.

Multiple unit classes

The COLL changes provide that an AUT may now have multiple unit classes, something that was not previously possible. The Revenue acknowledges that, as a result, certain necessary technical changes are required to bring the AUT rules into line with those for OEICs, in particular to ensure that there is no discrimination between different classes of unitholder.

Derivative strategies

The paper considers whether the current approach to the taxation of derivative strategies, in which the tax treatment of profits and losses derived from the use of derivatives broadly follows the treatment of those profits and losses in the accounts of the fund, remains appropriate in light of the use of more sophisticated financial instruments.

In particular, the question is asked as to whether the current ability for a fund to avoid taxation on amounts treated as capital profits in the accounts should continue. The Revenue's concern is that a "favourable" interpretation of the relevant accounting standard may expose the Exchequer to loss.

In addition, the Revenue wants to consult about the impact of the adoption of International Accounting Standards (IAS) in the UK. The potential for onshore quasi-hedge funds, which rely upon the accounting practice described above to avoid taxation at the fund level, has already been identified by the industry. Some clarity is needed as to how these funds would be taxed, although any departure from the general principle that tax should follow the accounts should, where possible, be avoided.

Distribution of capital gains

As a separate matter, the Revenue is concerned that changes to accounting standards, including the introduction of IAS, may make it easier for a fund to distribute realised capital gains. Currently, an authorised fund is entitled to distribute only amounts that are classed as income that has been taken to the distribution account.

However, unlike the case of investment trusts, there is no express prohibition on the distribution of surpluses realised on the disposal of investments by an authorized investment fund. This seems to be a minor issue, and one which should be capable of being resolved by proper implementation of the relevant accounting standard, rather than any change in law.

It is difficult to see why the distribution of capital gains - taxable in the hands of the investor - should concern the Revenue unduly although this may be a "corporate" philosophical objection to distributing capital where a "distribution" implies a receipt of income and there is a presumption of capital maintenance.

QIS funds

The final section of the paper addresses the new QIS fund. As an authorised investment fund, a QIS fund qualifies for the tax regime outlined above. However, the Revenue is concerned that the more sophisticated and less regulated QIS fund is not abused by the industry to package private investment activities into a fund structure and take advantage of the beneficial tax rules applying to authorized investment funds.

Two possibilities are outlined: one to exclude altogether QIS funds from the tax rules for authorised investment funds and tax a QIS fund as a company or a trust; the other to limit the application of the authorised fund regime to widelyheld funds, including widely held QIS funds.

Whilst a debate on the tax treatment of the QIS fund is needed, the proposals outlined in the paper, in particular that a QIS fund would not benefit from the authorised funds regime, would seriously restrict the growth in the QIS fund market and keep sophisticated investment funds offshore.

The proposal to exclude closely held funds from the authorised funds rules would equally place a number of private investment funds at risk. It is to be hoped that the Revenue can be persuaded that their proposals go too far and cannot be justified on tax avoidance grounds. In the meantime, the uncertainty introduced by the consultation over the tax regime for QIS funds makes it difficult to advise clients to establish a QIS fund, even where there is no desire to use the extensive derivative and/or shortselling powers that could be seen to be more problematic.

The paper also deals in very broad terms with wider issues of fund taxation. One question asked is whether the rules for unauthorized unit trusts (UUTs) and pension fund pooling vehicles (PFPVs) remain necessary in light of the COLL changes and the possible introduction of property investment funds (PIFs).

This is already being considered in relation to such funds investing in property as part of the PIF consultation although the proposals in the discussion paper are more widely drawn. One could observe that these vehicles serve particular purposes well and that there is no need to remove the rules applying to them simply for the sake of tidiness. It is, however, true that UUTs and PFPVs are not particularly common features of the investmentuniverse.

Where to next?

The discussion paper remains open for comments until 24 September 2004. Whilst a number of the proposals in the paper are initially concerning, in particular those concerning the QIS fund, we expect that the final approach should not prove as draconian, provided that views on the proposals are madeknown to the Revenue.

We, and others, will be preparing a response to the matters raised in the paper and would welcome any views that you may have on the impact of the proposals.

The fund community should take the opportunity presented by the paper to have a proper debate on the general regime for the taxation of funds. In particular, we consider that the proposals outlined in the paper do not go far enough in seeking to make the UK a competitive jurisdiction in which funds may be domiciled.

Rather than seeing investment funds as a potential vehicle for tax avoidance, the Revenue should acknowledge the important role played by the fund sector and follow the approach taken by its European competitors to grow their fund industries.

Without such a change in attitude, the ability to undertake sophisticated investment activities onshore, possibly in a true hedge fund, will remain a distant dream…

Paul Hale is a partner and Martin Shah a solicitor in the Corporate Tax Group of the London office of Simmons & Simmons, the international law firm.